Getting in the LDI Game

For many Canadian pension plans, 2007 was like an incredible hockey game with end-to-end rushes, bloody fights and terrible injuries, but that ends in a 1-1 tie. The players know it was extremely demanding and the spectators know it was very exciting, but for people that only see the score in the next day’s newspaper, it looks kind of boring.

For those in the markets, 2007 was demanding to say the least, with the subprime crisis and the seizure of global money markets, the implications of a soaring Canadian dollar (or sinking U.S. dollar) and the return of volatility to the stock market. Plan sponsors that were watching closely as the year played out will certainly be disappointed with the final score. As we can see in Chart 1 below, plan funded ratios dropped almost 10% in the second half of the year—just in time for year-end actuarial valuations for cash funding and financial statement purposes!

Asset mix The pension fund assets are assumed to be invested in a passive portfolio with 40% DEX Universe bonds, 30% Canadian equities, 15% U.S. equities (unhedged), 15% EAFE equities (unhedged) and rebalanced back to this mix on a monthly basis.

Liabilities Pension liabilities are assumed to be non-indexed. They have been determined based on the prevailing yields on long-term government of Canada bonds and are assumed to have a duration of 16.

Caveats The charts show the sensitivity of the model pension plan to market returns and changing interest rates only. No allowance is made for alpha from active asset management. No allowance is made for the funding of pension plan deficits nor for contribution holidays (the charts implicitly assume that cash contributions are being made equal to the value of pension benefits being earned on a current basis). No allowance is made in the liabilities for pension plan improvements or demographic-related factors.

These ups and downs beg the question: does running a pension plan really have to be a hold-your-breath-and-hope for-the-best proposition? In other words, does it have to be so risky?

Well, risk certainly can’t be avoided altogether. As for any complicated long-term financial vehicle, it comes with the territory. Badly-behaving markets are only one of myriad risks faced by plans. Other risks include someone absconding with the pension fund (fortunately, this is very difficult to do in Canada) or the pensioners living too long. The list goes on, with the worst risks probably being those that we can’t think of to list.

Each risk must be measured, mitigated and monitored to the extent possible. But market risk is the most obvious and consistent source of risk for pension plans. How can a pension plan fiduciary most effectively address their market risk position?

It’s tempting to use mathematics as a starting point; however, as Nobel Prize winner William Sharpe says in Peter Bernstein’s excellent recent book, Capital Ideas Evolving, “It’s dangerous to think of risk as a number.” Nevertheless, some framework within which to consider the issue is helpful.

To establish the framework, assume that we have a fully funded pension plan and then consider the following two scenarios:

Due to soaring stock markets, the pension fund earns 15% on its assets per year for five years, but at the end of that period, the company sponsoring the pension plan goes bankrupt and pensioners can only be paid 50¢ on the dollar.

Alternatively, the pension fund performs poorly, losing 5% of its assets per year, but when the company goes bankrupt, the pension plan is able to pay all plan members their full pensions.

We can agree that the second scenario is preferable to the first one, as unlikely as they both might appear to be on the surface. What isn’t described in the scenarios is what happened in the meantime to the value of the promised pensions (i.e., the liabilities). So in the end, it isn’t really just about the performance of the pension fund assets, it’s about the performance of the pension plan as a whole—in other words, the ability for invested assets to cover liabilities.

A pension plan’s funded ratio indicates the plan’s ability to cover its liabilities. A ratio of 100% or more means that liabilities are covered, and a ratio of less than 100% means that they are not. Pension plan fiduciaries can observe their market risk position by watching what the markets are doing to the plan funded status, as in Chart 1. The more jagged the line, the riskier the plan—a risk that will manifest itself as volatile cash contribution requirements and/or income statement impact (and for companies reporting in the U.S., as volatility on the balance sheet.). So the fiduciary should be assessing the degree to which the plan funded status can be expected to go up and down, rather than just focussing on the pension fund’s assets.

Of course, we can’t talk about risk without bringing in the impact on expected return. Return in this context is the rate of return on the plan funded status, not just the plan assets.

Any pension plan’s current risk/return position can be considered like in the diagram in Figure 1. Assuming that opportunities exist for making changes, moving the plan from its current position into the green zone would be unambiguously a good thing to do. More expected return for lower expected risk—it’s like having your cake and eating it too. A move to either yellow zone: lower expected risk and return or higher expected risk and return and higher risk may or may not be a good thing to do—that is a matter of circumstances and judgement. A move to the red zone would be a bad idea for anyone.

How can we make improvements? We can identify a three-step approach to moving a pension plan to a better risk/return profile:

Market risk for pension plans is dominated by sensitivity to long-term interest rates and stock market volatility. While stock market risk is taken in the expectation of earning a reward for risk, the interest rate risk does not bring the same expectation of reward.

Most pension plans are much more sensitive to interest rate changes on their liabilities than on their assets. When interest rates go down, liabilities go up by a lot more than the pension fund’s assets. Reducing this sensitivity, known as hedging the liabilities, moves the pension plan to a lower risk position. Traditionally, this would be done by shifting assets from equities to bonds, thereby reducing the expected return as well (see Arrow A in Figure 3). This is a valid approach, especially if shifting into a long-duration bond mandate. This has been a fairly typical move for many Canadian pension plans over the last 10 years. But because it sacrifices potential higher returns, very few plans have been tempted to hedge all, or even a significant portion, of their liability interest rate risk using this approach.

A more efficient approach to hedging interest rate risk is to use interest rate swaps (see “Introduction to swaps”). Interest rate swaps are extremely flexible and can be tailored to more closely reflect the liability cash flows and hence their interest rate sensitivities. And because swaps can provide more interest rate exposure per investment dollar, pension plans can hedge their interest rate risk without necessarily reducing their allocations to higher return-seeking asset classes. Implementing swaps to reduce interest rate risk could be done along Arrow B in Figure 3—a much more interesting proposition indeed.

Swaps do, however, come with a significant burden: directly entering a swaps contract requires a significant amount of work, including fiduciary education, due diligence and contracting. The cost involved makes it prohibitive to all but the biggest plans.

But recently, access to swaps has been “democratized.” Introduced first in the U.K., and now emerging on this side of the ocean, are traditional pooled fund structures that use swaps to provide interest rate exposure. The pooled funds are offered in a suite of funds, with each individual fund focussed on providing exposure to interest rates in a particular target range of years—for example, years 1-5, 6-10, 11-15, etc. Pension plan liability cash flows can be closely matched by investing the appropriate amount in each pooled fund bucket, as illustrated in Figure 4.

With this approach, the pension fund avoids the complication of entering into the swap contract directly by investing in the pooled funds, leaving that messy administrative business to the investment manager. And since the pooled funds tend to have low minimum investment thresholds, all sizes of pension plans can consider this approach.

Step 2: Add More Diversification

Additional asset classes offer pension funds an opportunity to move into the green zone with higher expected returns and/or lower expected risk. The mathematics will show that is because the ups and downs of each asset class don’t coincide, at least not exactly, with the ups and downs of other asset classes. In other words, if one asset classes zigs when another zags, then the zigs can offset the zags!

There has been growing recognition of the narrowness of past investment practices following the disappointing stock market returns in the early part of this decade. Cutting-edge pension plans have been leading the search for broader market exposures (referred to as “beta exposure”) into emerging market equities, commodities, infrastructure, timber and private equity, among other types of assets. While some of these asset classes remain elusive for smaller and medium-sized plans, most are now accessible via pooled funds and/or exchange-traded funds. And these market exposures come relatively cheaply as well, since the expected returns are not dependent on manager skill.

Pooled funds that combine a vast array of traditional and non-traditional market exposures will be the next frontier. While you could think of these as balanced funds for the 21st century, they’ll be considerably more diverse than we’re used to seeing. Just starting to emerge now, these funds will provide plans of all sizes with compelling Step 2 opportunities.

Step 3: Seek High-quality Value-added from Active Management

As the arrow in Figure 2 indicates, this step will actually increase total plan risk but only by a very modest amount at first, since active management risk should be independent of market exposure risk. Traditionally, most pension funds have looked to their traditional asset class investment managers to add value by outperforming their given index. More recently, we’ve seen a proliferation of hedge funds purporting to produce return without underlying market exposure (known as “pure alpha”). Any such return is conditional on skill. Pension funds face two important questions when considering an allocation in this step: do you believe that an investment manager can produce value-added returns on a sustainable basis, and if so, do you think that you can find them?

Bigger plans have an advantage in this space because they can dedicate more resources to those questions, and because they can more effectively diversify across a number of investment managers. While this advantage will probably persist, opportunities do exist for smaller plans to participate, presuming they believe in the potential for value added through manager skill. Multi-strategy hedge funds and hedge fund-of-funds make it possible for almost all plans to implement this step.

Putting it All Together

While each step should be worthwhile on its own merits, combining the three steps can be especially powerful, as we can see in Figure 5. The combination offers the potential to move the plan in the desired direction.

As a result, we have the framework for an “ideal” future investment policy: the three-layer solution shown in Figure 6. Hedge the liability risks to the extent possible. Add a layer of diversified market exposures to target returns above the liability hedge, as desired. And for the believers, add a layer of diversified alpha.

The ideal investment strategy is theoretically justified and practically possible. Each layer in the solution can be structured and optimized independently, then blended together in the right proportions to meet the investment objectives of any plan. The framework is common to all plans, but the resulting investment strategy will be tailored to each plan’s circumstances.

The Bottom Line

This is exactly the strategy that the best pension funds are pursuing, or so it appears from the outside looking in: relentlessly pushing into the green zone by reducing unrewarded risk, seeking out additional asset classes and beating the pack to unexploited value-adding opportunities.

The lesson for the rest is simple yet demanding: if you can, you should. From a fiduciary perspective, a move to lower expected risk without sacrificing expected return is more than a no-brainer, it is a duty.

That’s not to say that pension funds should invest in anything and everything—they shouldn’t invest in things that they have well-considered views against, or anything that they don’t understand. But as transparent, soundly-structured, cost-effective investment vehicles become increasingly available across the three steps, justifying inaction will be increasingly difficult.

At the risk of torturing the analogy, if pension plans are like a hockey game, shouldn’t you put the best available players on the ice?

Introduction to Swaps

A swap is an agreement between two parties (one of whom is usually an investment bank) to swap one stream of payments for another, one of which is generally fixed; the other, variable or floating. Each swap is an individually tailored contract (sometimes referred to as “over the counter” or “OTC”) and can be based on any terms agreed upon by the two parties. The first swaps, created more than 30 years ago, were interest rate swaps. Now the list of swap exposures is extensive, including stock market returns, inflation, credit and commodities.

Figure 7 shows a simple example of an interest rate swap. On the left, we have one party willing to swap fixed cash flows: 5% of $100. These cash flows are exchanged for payments based on a floating interest rate applied to the same amount. Based on expectations about future interest rates, these are expected to be $4, $6 and $5.

An integral part of any swap is that, at the outset, the present value of each future stream of cash flows is equal. After the swap has begun, the fixed payments do not change (the agreed-upon long-term interest rate), but the floating payments fluctuate with actual short-term interest rates. Thus, one party will gain at the expense of the other as interest rates change.

As the swap position becomes positive, one party will have exposure to the creditworthiness of the counterparty. In practice, this risk can be very well managed via collateralization. This means that when one party owes money to the other, it is passed across as collateral (in securities of equivalent value) prior to payment. In practice, swaps are usually valued daily and collateral payments are calculated accordingly.

Therefore, pension plans can use interest rate swaps to hedge interest rate risk by swapping the interest earned on cash investments for a fixed long-term rate of interest. If interest rates fall, an increase in plan liabilities will be accompanied by an increase in the value of the interest rate swap. If interest rates rise, the negative swap value will be offset by a reduction in plan liabilities.

Paul is responsible for client servicing and business development with Canadian institutional investors at Barclays Global Investors Canada. paul.purcell@barclaysglobal.com